#FederalReserve

Credit is normalising, but… excellent commentary from Narrow Road Capital

If you haven’t done so already, we strongly encourage people to sign up to Narrow Road Capital’s insights on high yield and distressed credit markets. Even better it is free. Jonathan really puts together his thoughts in a very digestible format.

Jonathan has penned this excellent summary of the state of debt markets and cautions us not to get too excited. We have highlighted the things that stood out for us.

Credit is Normalising, But…

Credit securities, both in Australia and globally are getting back on their feet. The bookbuilds this week of $1 billion of corporate debt by Woolworths, $1.25 billion of RMBS by La Trobe and the $500 million of hybrids by Macquarie are all positive signs. However, secondary trading in many debt sectors is light and a few sectors remain moribund. Whilst the signs are generally encouraging, three dark clouds on the horizon point to the possibility of worsening conditions.

The leverage fuelled, panic driven sell-off started on February 24 and ran until March 23 . The circuit breaker was the Federal Reserve’s announcement of “unlimited quantitative easing”. At that time, there were widespread reports of global investors struggling to sell even the highest quality government bonds. Given how dire it was, it has been a relatively quick journey back from the abyss.

In Australia, major bank senior bonds recovered first and are now trading at similar spreads to three months ago. Corporate and securitisation debt has had a far slower recovery with trading remaining patchy. The large issuance this week by Woolworths and La Trobe, as well as a smaller issue by Liberty showed that buyers were willing to return. But unlike major bank bonds, spreads on corporate and securitisation debt have been reset at much higher levels.

At the same time as credit markets are improving, the economic outlook is also brightening in some ways with the gradual easing of restrictions on business. There is a growing view that the worst of Covid-19 has past and that a vaccine or drug treatment might not be far away. The optimism of the human spirit seems boundless with some investors seeing the pandemic as just another opportunity to buy the dip.

Where many investors are seeing mostly positives, I’m seeing mostly negatives. Australia has gone nearly 30 years without a recession leaving our economy fat and lazy. Asset prices (notably housing) have been propped up by population growth, credit growth and interest rates cuts, all factors unlikely to repeat. We’ve had over a decade of Federal Government deficits, destroying the legacy of Peter Costello’s decade of fiscal discipline. The economic buffers we had before the last crisis have been frittered away, leaving Australia poorly placed to withstand and rebound from the current economic and financial crisis. Given this backdrop, there are three standout risks for investors to factor in.

Remember 2007 – Fundamentals Matter

The bounce back in the last two months reminds me a great deal of 2007. In July 2007 credit markets slammed into a brick wall with credit default swaps and CDOs taking substantial damage. Bank bonds sold off as the riskier European banks started to have their solvency questioned. Yet after an initial shock, some of the markdowns turned around offering a window to get out with limited losses.

At first, equities and property continued on their merry way oblivious to the damage in credit markets. Australian equities peaked in October 2007 but held near record levels until January 2008. In December 2007, the property sector was slammed as Centro disclosed it couldn’t roll over its debt. Both at the time and in hindsight, the second half of 2007 was a bizarre period where fundamentals and market prices were so divergent. Given the medium term outlook for Australia includes significant unemployment and business failures, it is hard not to conclude that most investors are ignoring the fundamentals, just like they did in 2007.

Quantitative Easing

If the global debt markets are likened to plumbing, then quantitative easing is the duct tape used to cover the cracks. Central bank buying of government debt has delivered liquidity to debt markets at a time when governments and corporates are going on record borrowing sprees. If investors weren’t able to sell assets to governments via quantitative easing programs, they wouldn’t have capacity to buy the new issuance and bond yields would soar. Quantitative easing is beating back the bond vigilantes temporarily.

Australia has been a late entrant to this charade but is making up for lost time with the RBA hoovering up 7% of Australian government bonds in two months. At this rate, they will own the entire government bond market by the end of 2022. Whilst the RBA buying government bonds is the main game, there’s also been cheap funding for banks and the securitisation market. It’s no longer a case of merely providing liquidity against super safe assets, the recent purchases of sub-investment grade securitisation tranches come with the meaningful possibility of capital losses.

Whilst quantitative easing has yet to hit its unknown limits in developed economies, emerging markets have shown what happens when citizens and investors lose confidence in a fiat currency. The widespread use of US dollars in Argentina, Ecuador, Lebanon, Venezuela and Zimbabwe is the practical outworking of a country adopting funny money practices. At some point, the duct tape stops working and the value of the currency goes down the drain.

Global High Yield and Emerging Market Debt

Whilst most credit sectors are recovering well, corporate high yield debt and emerging market debt are on life support. The US high debt market has recovered around half of the losses that occurred since mid-February. However, this has been a quality driven rally with BB rated companies able to issue whilst B- and CCC rated companies are stuck in the doghouse. Several failed transactions have been a clear warning that lenders have little appetite for companies that can’t demonstrate their solvency in the medium term. The weaker airlines, energy companies and tourism associated businesses are looking at their cash positions and making calls about when to enter bankruptcy.

It’s a similar outlook for the weaker sovereign borrowers, particularly in emerging markets. The years leading up to this crisis saw an explosion in lending to the lowest rated sovereigns. Many of these countries are now turning to the IMF for bailouts; at last count roughly half of the world’s countries had put their hands up for help. There’s a global wave of jobs that will be lost as the weakest companies and countries are forced to reign in their spending. Whilst investors are pricing in a solid probability of defaults, they are ignoring the wider economic impacts of defaulting borrowers on the global economy.

Written by Jonathan Rochford for Narrow Road Capital on 16 May 2020. Comments and criticisms are welcomed and can be sent to info@narrowroadcapital.com

Disclosure

This article has been prepared for educational purposes and is in no way meant to be a substitute for professional and tailored financial advice. It contains information derived and sourced from a broad list of third parties and has been prepared on the basis that this third party information is accurate. This article expresses the views of the author at a point in time, and such views may change in the future with no obligation on Narrow Road Capital or the author to publicly update these views. Narrow Road Capital advises on and invests in a wide range of securities, including securities linked to the performance of various companies and financial institutions.

Drinking the UnKool-Aid

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It appears President Trump has been bullying the US Federal Reserve to drop rates by 1% and get them to reopen the spigots on QE. What he is failing to grasp is that businesses invest because they see a cycle, not because interest rates fall.

Trump tweeted,

China is adding great stimulus to its economy while at the same time keeping interest rates low. Our Federal Reserve has incessantly lifted interest rates, even though inflation is very low, and instituted a very big dose of quantitative tightening. We have the potential to go…up like a rocket if we did some lowering of rates, like one point, and some quantitative easing. Yes, we are doing very well at 3.2% GDP, but with our wonderfully low inflation, we could be setting major records &, at the same time, make our National Debt start to look small!

This is a frightening proposal. Rates are at 2.25~2.50%. Although it masks a more important reality. Can Trump avoid a market calamity ahead of the next election? The real engine of the economy is slowing.

Despite the headline US GDP print of 3.2%, consumer spending and business investment slumped to the lowest levels under his presidency. Business investment spending was dominated by “intellectual capital” (soft) which is a pretty hard metric to put a reliable number next to. Equipment and structures (hard) contribution to business investment was near as makes no difference zero. Personal consumption of durable goods slumped to their lowest reading since 2011. Wholesale inventories (ex-autos/petroleum) surged ahead of sales.

Trump might argue China is adding stimulus. He is right. China’s Aggregate Financing (approximately system Credit growth less government borrowings) jumped 2.860 billion yuan, or $427 billion – during the 31 days of March ($13.8bn/day or $5.0 Trillion annualised (a Japanese GDP)). This was 55% above estimates and a full 80% ahead of March 2018. This pump priming added 8% to the Chinese stock indices but since then the market has been rolling off.

The world does not need more debt to be inflated away to get us out of the current mess we are in. A recession is inevitable. To put it into context, the world, since GFC, has added $140 trillion in debt for a grand total of $20 trillion in global GDP growth. That is right. $7 of debt only got us $1 of GDP. So if the Fed acquiesces President Trump he will probably get even worse metrics.

Then again perhaps we can take the words of a venture capitalist, Chamath Palihapitiya, who said on CNBC that “central banks have created an environment where major downturns and expansions are almost impossible.” It is statements like this that almost guarantee that central banks have lost control. Central banks have one role – ensure that markets maintain “confidence”. Powell’s latest move to cut rates after such a shallow peak tells us that “confidence” is waning. 

New Fed Chairman to trigger historic stock market crash in 2018 – ZH

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ZeroHedge writes that the new Fed Chair will trigger an historic stock market crash in 2018. Glad to have loaded up on put options in recent weeks. Perhaps the cheapest priced products in an asset bubble everywhere world. Some shorter dated put options priced as little as 2c in the dollar. Risk is definitely not being priced for fear. Maybe why Blackstone has built up $22bn of short positions in recent months.

44% of Americans can’t raise $400 in an emergency. It is actually an improvement

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44%. This is actually an improvement on the 2015 survey that said 47% of Americans can’t raise $400 in an emergency without selling something. The consistency is the frightening part. The survey in 2013 showed 50% were under the $400 pressure line. Of the group that could not raise the cash, 45% said they would go further in debt and use a credit card to pay It off over time. while 25% would borrow from friends or family, 27% would forgo the emergency while the balance would turn to selling items or using a payday loan to get by. The report also noted just under a quarter of adults are not able to pay all of their current month’s bills in full while 25% reported skipping medical treatments due to the high cost in the prior year. Additionally, 28% of adults who haven’t retired yet reported to being largely unprepared, indicating no retirement savings or pension whatsoever. Welcome to a gigantic problem ahead. Not to mention the massive unfunded liabilities in the public pension system which in certain cases has seen staff retire early so they can get a lump sum before it folds.

Would you trust a Tsukiji fish trader or the government to forecast the tuna market?

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Believe all the propaganda from governments and central banks you want. This letter from Perry Capital tells us all we need to know. The fish smells off. This fish trader has had enough. They’re essentially saying the amount of manipulation in markets is too high and they can’t conscionably manage people’s money within that environment. Essentially they’re not prepared to advertise fresh deep ocean tuna to clients when it’s fished from a farm located downstream from a sewage plant and an oil tanker spill. At the same time we see Deutsche Bank shares make new lows and more clients ask for their money back. The run has started.

Dear Investors

Over 28 years ago, Paul Leff and I started a money management firm. Our catalyst oriented value approach combined financial analysis and active engagement with management teams to create attractive opportunities with asymmetric risk/reward. During this time, we provided capital to many companies and countries facing stress and distress. Our style worked well for many years and we had the pleasure of hiring, training, and working alongside some of the best people in this business who have significantly contributed to the success of Perry Capital. Although I continue to believe very strongly in our investments, process and team, the industry and market headwinds against us have been strong, and the timing for success in our positions too unpredictable.

As a result, we have decided to wind down Perry Partners LP. We will manage the Fund’s wind down in the most effective way possible. We have been raising cash and plan to return a substantial amount of the fund’s capital in the beginning of October. The rest of the portfolio will be monetized in an orderly fashion and will be categorized by expected liquidation horizon: short term (2-3 months), medium term (6-12 months) and longer term (greater than I year).

We will prudently manage the remaining investments down over time. The short and medium term investments will be sold opportunistically but efficiently so as not to move markets or harm investment value. The longer term investments, for example the GSEs and some of the RMBS putback securities, will take time and energy to successfully realize an appropriate result. Our core team remains in place so that no effort or diligence will be compromised. We are committed to these investments and to you, our partners.

Going forward, we intend to return your capital quarterly. I am completely dedicated to making sure this process goes as smoothly as possible and have no other plans. Our interests are aligned — the Perry funds represent almost all of my liquid capital.

Over the next few weeks, I hope to speak with many of you. I want to personally tell you how much I have valued your support and trust. Thank you for your partnership over the years.

All my best,

Richard Perry

FOMC – “better positioned to offset large positive shocks!”

I’ve just read through all 16 pages of the July 26-27 FOMC minutes and boy is the language a treat. Here are some of the stupid things that were written up (and you have to ask yourself would you entrust your livelihoods to these people when they can look you in the eye with this garbage?):

“The risks to the forecast for real GDP were seen as tilted to the downside, reflecting the staff’s assessment that both monetary and fiscal policy appeared to be better positioned to offset large positive shocks than adverse ones.”

Think about those words – “better positioned to offset large positive shocks” – what a load of hooey. If central banks around the world could buy ‘positive shocks’ believe me they would take everyone they could get. Sad thing is with chronically low interest rates, growth is slowing, wages are falling and the RoW is in an even worse position.

The report on the current conditions swings between positive and negative and secretly admitting they have little clue. Every risk they talk of seems skewed to the downside.

“In addition, the staff continued to see the risks to the forecast from developments abroad as skewed to the downside. Consistent with the downside risks to aggregate demand, the staff viewed the risks to its outlook for the unemployment rate as tilted to the upside. The risks to the projection for inflation were still judged as weighted to the downside, reflecting the possibility that longer-term inflation expectations may have edged lower.

So with that in mind, the US Fed has created its own dilemma. Since raising rates from nothing to next to nothing in Dec 2015, growth has stalled. Q2 came in at half estimates and Q1 was revised below 1%/ Cutting rates from here would be a hugely negative signal for markets and raising rates would brake the economy harder. So they talk the game of scope to raise rates in 2016 yet the minutes don’t give any real sense of confidence that they can carry it out.

They talk up consumer spending but note business investment continues to slow. If businesses aren’t investing because they can’t see the cycle, is it any wonder.

“Business fixed investment appeared to have declined further during the second quarter, with broad-based weakness in equipment and another steep drop in drilling and mining structures…”

This was also a doozy:

“However, during the discussion, several participants commented on a few developments, including….the elevated level of equity values relative to expected earnings, and the incentives for investors to reach for yield in an environment of continued low interest rates…It was also pointed out that investors potentially were becoming more comfortable locking in current yields in an environment in which low interest rates were expected to persist, rather than engaging in the type of speculative behaviour that could pose financial stability concerns.”

Investors getting more comfortable? Are you kidding? As I pointed out in the past in order to hunt for yield poor unsuspecting pensioners are being forced out the quality curve taking on unnecessary risks.

This was also amusing were it not frightening at the same time. For central banks that have next to no credibility remark that they must protect it:

“Ms. [Esther L.] George dissented because she believed that a 25 basis point increase in the target range for the federal funds rate was appropriate at this meeting. Information available since the June FOMC meeting showed solid employment growth, economic growth near its trend, and inflation outcomes aligning with the Committee’s objective. Domestic financial conditions had eased since the U.K. referendum. She believed that monetary policy should respond to these developments by gradually removing accommodation, consistent with the prescriptions of several frameworks for assessing the appropriate stance of monetary policy. She believed that by waiting longer to adjust the policy stance and deviating from the appropriate path to policy normalisation, the Committee risked eroding the credibility of its policy communications.”

The FOMC stands for “Fed Open Market Committee” although I wonder whether it should be “Foolishly Optimistic Myopic Comedians”